Core conundrum

International institutions that want core Japanese real estate should get real about where they can get it.

With almost $2.7 trillion of real estate, Japan has the second largest market in the world.

And yet it is one of the hardest markets for international institutional capital to make inroads. To this day, that is of perennial frustration for managers with a core investment strategy: Yes, they can raise money for the stuff, they can exit the stuff, but they just can’t get at it in the first place.

The thesis behind buying core real estate in Japan is sound. Thee backdrop is of improving market sentiment, stimulated further by Abenomics – the economic stimulus programme by prime minister Shinzo Abe that is using a mixture of quantitative easing, infrastructure investment and currency devaluation to try and boost the economy.

Against that, there is strong faith among Japanese real estate executives that rents have bottomed out. They have even risen slightly in some areas.

Once first movers absorb 200 basis points to 300 basis points of existing vacancies, then we should also see cap rate compression, particularly for Japanese offices.

Now is a good time to buy good quality, income-producing assets, PERE heard frequently in Tokyo this week. The J-REIT market knows it and is on course to suck in approximately $13 billion from retail investors by year-end. And they are willing to buy outside of Tokyo’s Marunouchi business district and a small handful of other central wards. Offshore institutions, on the other hand, have remained stubborn about which postcodes they are willing to transact in, much to the chagrin of managers in the city which cannot meet all their prerequisites.

S-Class property (Japanese market speak for super prime) is the preserve of long-established corporations like Mitsubishi and Mitsui. Just look at the sale of AIG’s headquarters in Marunouchi in 2009 to Nippon Life Insurance. Practically the last office tower in foreign hands up until the insurer required a bailout at the height of the global financial crisis, once for sale it was never going to be purchased by another international firm. And the Japanese will make sure the 400,000 square footer won’t become available again anytime soon.

There was talk of international institutions needing to accept they cannot project international expectations of core real estate onto Japan. Managers on stage at PERE’s Forum: Japan on Wednesday this week warned that expectations of centrally located acquisitions where 80 percent of the return comes from income would meet with disappointment. An entry yield higher than 4.5 percent was very unlikely.

One manager came up with the moniker ‘Tokyo core’ as a stand-in definition that should be embraced instead. Secure income would still be the focus but Greater Tokyo, or even outside of Tokyo, would need serious consideration. Further, given the city’s monoliths are largely unavailable – the sales of the Shiba Park Building and Pacific Century Place when THEY happen, are outliers – strategies wrapped around taking down those make little sense. ‘Tokyo core’ means smaller buildings, but there are more of them to buy.

Institutions bent on including Japanese real estate into their mix could do worse than look at what opportunity fund managers are engaging with. Take Fortress for example, which since the beginning of the global financial crisis has taken the mantle of running Japan’s most active private equity real estate business. For its first $800 million fund it placed the capital into 23 separate transactions averaging $40 million each in size. Its second $1.6 billion vehicle, which closed two quarters ago, has already picked up 18 deals. Fully cognisant of how fussy international buyers can be, the firm told PERE’s audience it expected to transact with a “defused” and “less organised” end-buyer market that would almost definitely include the J-REITs but also the Japanese private REITs which are akin to private open-ended funds. GreenOak Real Estate, to adopt another example, buys and sells around the fringes to high net worth Japanese families and corporates. While its deal sizes oftentimes are even smaller than those of Fortress, it performs a similar function: it manufactures core real estate.

PERE did hear something of one or two of Japan’s stalwart corporations that have been prompted, in the name of good international relations, to sell some of their balance sheet assets, preferably to offshore capital. But that is hearsay. In the meantime, this week’s visit to Tokyo has only underscored the point that international institutions which want Japanese core should get real about where they can get it.